Your Funds: Lessons from an ETF fee fight

The fee fight between the Vanguard Group and Charles Schwab, over which firm has the lowest-cost exchange-traded funds, is a lesson in pennies saved being pennies earned.

The entire back-and-forth between the two ETF giants carries a number of messages for investors on how to best capture those pennies and turn them into real dollars. The problem is that both companies were so busy crowing about their moves that most investors missed what was said between the lines

On Sept. 21, Schwab lowered fees on its exchange-traded funds to make them the lowest-cost entries in their categories. Vanguard's response came on Oct. 2, when it announced that it was adopting new benchmarks over the next six months for nearly two dozen index funds, a move that would allow it to cut costs just enough to retake the cost lead over Schwab.

Current shareholders aren't getting rich on the savings. Schwab's 50 percent cut in costs on U.S. Large Cap only saves shareholders 40 cents on every $1,000 they keep in the fund for a year. Vanguard's cuts, in some cases, will save its shareholders half that amount. All told, an investor with $10,000 in the ETFs is likely to see less than $5 savings over the next year.

But focusing on the savings for current shareholders misses the point, because the real lessons here are for any investor who is pursuing an indexing strategy but is not doing it using the lowest-cost ETFs. Those lessons are:

Traditional index mutual funds are out; use the ETF in the same space. With the exception of a very few cost leaders — mostly institutional funds requiring big holdings — ETFs are dramatically cheaper than traditional funds covering the same indexes. So while investors in a fund like T. Rowe Price Equity Index 500 won't complain about an expense ratio of 0.30 percent, they are paying at least six times more than the best of the ETFs. Making that change would let shareholders realize an extra quarter-point of return per year, and that adds up.

And that's an example of a good traditional fund. Lipper Inc. shows plenty of S&P 500 index funds — particularly B and C share classes — with costs well north of 1 percent.

The one advantage traditional funds have is that an investor can dollar-cost average into the fund without paying repeated commissions, but there are no-transaction-fee ETFs that offset this advantage. Index ETFs have a slight tax-efficiency edge over traditional index funds too.

Use ETFs for your index investments, even if that changes what you keep inside and out of retirement accounts. A lot of investors settle for high-cost index funds because they are in the retirement plan. Again, that's a mistake from both the expense and the tax standpoint.

If you are an investor who wants index funds and the only options in your retirement plans are costly ones, do your indexing outside of the plan and in taxable accounts, and use the program to build your portfolio around that index core.

And if you hold high-cost index funds in a plan from a former employer, it's time to convert that account to a self-directed IRA, allowing you to move your core holdings into the low-cost ETF equivalents. Shaving those costs can add an extra 1 percent or more to your returns; that's free money, and particularly important to capture at a time when yields are so low and the market is particularly nerve-wracking.

Stop worrying about who built the index; all that matters are the assets it covers and the cost for getting that exposure. There are a lot of different indexes and the academics and management wonks have a tough time figuring out the difference performance-wise between the index providers. Vanguard's change represents its third major index provider in recent memory.